This is the fourth post on a quarterly set of numbers from Bank of America. That post sent my in-box on fire. The disagreement was absolutely vehement. Even when I mention global warming I do not stir up passions like this.

If you want to follow the saga read the posts in reverse order. Start with this post, then this and then this. Finally get to this current post. However if you are willing to accept my assertion that bank margins are rising regardless of subsidies then just ignore all but the first post.

I fully agree that – if at the moment – the FDIC guarantee were removed then Bank of America would fail. That failure would happen regardless of whether Bank of America is actually capital adequate or not.

However if the guarantee were removed the few banks around that were considered solvent would be flooded with money from people who wanted to put it there.

They would get those deposits very cheaply. Really cheaply. Free in fact.

The lending situation would be truly diabolical though. The rate customers would pay would go up sharply.

Bank margins would be truly spectacular. The problem would be survival to take advantage of those margins.

There is only one reason at all you are paid interest on bank deposits. It is that they are guaranteed.

Go to Bankrate.com. Look up the highest rate you can find. It is usually Corus Bank – which as noted here – is truly diabolical.

If you want to attract deposits you have to compete with Corus Bank. Corus Bank has those deposits and has the ability to attract them purely because it is guaranteed.

Note this. The guarantee raises the number of serious competitors in the deposit market. It raises the cost of deposits and it hence lowers bank margins.

Yes I stand by the assertion that if the guarantee were removed bank margins would rise – and deposit costs would fall.

Now when is it that my readers - usually with good economics training - stopped believing that the main determinant of margins is competition - and that subsidies given widely do not increase the income of the receiving industry - but just get competed away?

Bank revenue is rising. It is rising faster when governments guarantee their funding – but it is nonetheless rising pretty well across the board. The explanation for that rise is at best in part taxpayer subsidies. But that is not the only explanation. The competitive dynamics are far more important in explaining why revenue should rise.

Why is it that people have given up believing that competition is the main determinant of margins?

It is simply not true. Look at the numbers and the interest margin was widening sharply until the third quarter of 2008. Indeed interest revenue was a record every single quarter of last year – and that was the case at most banks.

Bank of America did not get any guarantees until that point. You can do the maths on the guarantee and they cannot explain the massive surge in the fourth quarter (too little money, too late). In the Bank of America case most of the guarantees were backstop after they purchased Merrills. They happened this year and hence outside the fourth quarter.

Revenue is rising at pretty well every bank I look at. Doesn’t matter if it is in America or not. It doesn’t matter whether it got a lot of government assistance or not.

Just accept it – for franchise banks – those that have good access to deposits or other sources of funds – revenue for a bank is rising.

It rises faster if the government will lend you wholesale money at government interest rates. But it is rising regardless.

This should not surprise people but there is resistance. In the boom there was no government assistance – and yet interest margins went down and down and down and down.

The banks levered themselves up further and further to get what they deemed acceptable ROEs.

At the moment the reverse is happening. Margins are going up and up and banks can’t de-lever themselves fast enough to survive.

John

PS. Just to further rub in the numbers - a liquidity trap means people save cash rather than spend. That is the macro problem.

So deposit balances are growing sharply. Bank of America deposits were up from 492 to 583 billion over the past year. I think that is good news for Bank of America. The cost of those deposits on average was down sharply.

Further - the non-interest bearing deposits were up by 25 billion. The bank gets to lend those new deposits at marginal loan rates slightly above their average loan rate of 560bps. One and a half billion dollars of the rise (annualy) is explained just by those numbers. The vast increase in the extra low-rate deposits explains a good proportion of the rest.

If you think that bank revenue is rising simply because of the government guarantees then you are letting ideology get in the way of the numbers. Bank deposits are rising. The cost of those deposits is falling. Banks with good franchises are finding that they don't need to chase to get zero rate deposits.

The opportunties in banking are wonderful - provided you can survive to take advantage of them.

Obviously this number has been getting bigger over time – and very dramatically bigger this year and particularly in the fourth quarter.

So what is it? The credit loss series for a bank? No – but it is a bank.

It is – wait for it – the quarterly net interest income for bank of America measured in millions of dollars.

It’s a good number to be big – and it is getting bigger rapidly now.

The fee income is also growing but only if you net out trading losses.

Felix Salmon objected (quite strenuously) to my pre-tax provision number in the long post. His objection is here.

Well here is the oddity. Other than for banks with substantial trading income (or losses) the fourth quarter has been an absolute record at just about every bank I am looking at. Sure if your losses are huge then your net interest income could be going backwards (as per Corus bank). But that is the exception. If this trend continues (and I think it will) then my pre-tax, pre-provision estimate in the long note is dramatically low whereas Felix was sure it was high.

Saying something nice about banking is certainly not the common parlance in the blogosphere. Yves at Naked Capitalism for instance commented on this section – quoting from a WSJ article:

From the Wall Street Journal: Citigroup executives are attempting to strike a seemingly impossible balance: Run the business in a way that will please their new federal masters, but also help the bank rebound from $28 billion in losses over the past five quarters.

Yves: That is another company-serving bit of spin. Does anyone think, with pretty much all advanced economies contracting and deleveraging likely to continue, that there are great profit opportunities out there?

Well yes Yves. Even with pretty much all advanced economies contracting there are opportunities in banking.

Indeed provided you can maintain access to funding the opportunities in banking are the best that they have ever been in my life. The margins are massive. Many people want (even need) to borrow money – and if you have money to lend you can select on the absolutely best credits. Your risk is much lower than it was on the average loan in the boom. The implied return on equity is much higher.

Happy days.

Of course they are happy days only if can maintain your funding (far from being a given) and you do not have losses so big from the boom that you will be wiped out (also far from being a given).

But in the past most banks that have got into trouble have been recapitalised by pre-tax, pre-provision earnings. And at the moment pre-tax, pre-provision earnings are going up.

For the record this is very different to Japan. In Japan bank spreads collapsed to 30bps. They did this because of the vast excess deposit bases at zero interest rates. But I cannot find another banking crisis in which bank spreads have fallen. Does anyone else know one?

Citigroup (once Salomon Smith Barney) in Sydney used to have the biggest and best Christmas parties.

Picture this: a balmy Sydney night and the investment banking clients and the whole 30ish Sydney investment banking crowd converge on a warehouse on the docks. Girls in bikinis serve champagne to blokes in suits with no ties and that dishevelled look you get when you have drunk too much.

There is always a band. A big name band – but the identity is kept secret until about 10.30pm when the act comes on.

One year it was Jimmy Barnes. That might not mean anything to an American – but he is the iconic aging rock-and-roller here. His original band (Cold Chisel) sang the Vietnam song that still gets everyone singing around a party (Khe Sanh). But in his solo career his biggest hit was a song called "Working Class Man".

My single most enduring memory of the bull market is a thousand drunk investment bankers howling at that song and the top of their voice:

Tuesday, February 24, 2009

This blog aims to admit its mistakes. This is an admission that this post was spectacularly wrong.

The main reason why the that post was wrong was that I assigned a very large value to AIG's life insurance businesses - and in the meantime pretty well every life insurance company in the world has imploded. (See Hartford for a good example.)

With the written down value of life insurance companies (and AIG is fundamentally a life insurance conglomerate) there is no hope that core bits of AIG can be sold in any reasonable time frame. Hartford might come back as Peter Eavis posited in the WSJ - but I am not holding my breath. Likewise there is some hope that the life insurance bits of AIG can find a bid one day. But not today.

AIG was about 50% life insurance, 40% property and casualty and 10% the rest which included some very bad bits (mortgage insurance in the US) and some truly unbelieveably bad bits (AIG Financial Products).

Even if it had not been for AIG Financial Products a company as dependent on life insurance as AIG would be in deep trouble now. It would - for instance - almost certainly be trying to raise capital in the same manner as Manulife.

Saturday, February 21, 2009

FDIC taking over WaMu and forcing Wachovia to the altar were unusual events not because the banks were large but rather because the banks were arguably viable when the FDIC acted. WaMu was capital adequate when taken over. My view is that it would – if left to its own devices – have survived – though it was touch and go. Without implicit FDIC support it was done for. Wachovia actually found a buyer without government support.

The FDIC usually waits until very late in the piece to take over a bank. With very few exceptions banks are shockingly insolvent by the time the government acts.

Lets do a comparison. WaMu still had 8 billion of pre-tax, pre-provision income – and that was enough to deal with what I thought were likely losses (30 billion or so – when WaMu was predicting 20 billion).

By contrast Corus bank - not yet taken over - is truly unremittingly awful. The the pre-tax, pre-provision income has disappeared. Banks should probably be confiscated before that event – but whatever – when that happens no amount of “voodoo maths” will save you.

So if you want to see what a truly insolvent bank looks like look at Corus Bank. I am not telling you anything new – they have signed written agreements as to how they will manage themselves and they have paid their senior staff retention bonuses so that they can manage. Here is an extract from their annual results.

Nonaccrual loans have grown to $1.5 billion, more than one-third of total loan balances outstanding at December 31, 2008. Combined with other real estate owned (“OREO”) of over $400 million at year end, most of which was foreclosed on during the last quarter of 2008, Corus’ nonperforming assets at December 31, 2008 totaled $2.0 billion. This extraordinary level of nonperforming assets put such negative pressure on Corus’ net interest income that it fell below zero for the quarter ended December 31, 2008. Empasis added.

To get an idea of how bad this is, non-performers were five times capital. Negative net interest income and there is no future – none, nada, zip. There is no income to bail you out.

Anyway what is strange is that some banks in America look like this – and others have non-performers of well under 1 percent. The system may be solvent (and I think it is) but there will be a few more Corus banks out there.

John

PS. This is a personal disgrace. I read Corus’s accounts in 2006 and never shorted them. That was despite a stated business model of being a specialist lender to the developers of condo projects.

PPS. The retention bonuses for the staff – critical staff in keeping this thing run – are – wait for it – 125 thousand dollars. When you see multi-million dollar retention bonuses to the people who failed what you see is theft. Whether the 125 thousand is theft is a matter of taste – but it is almost certainly a practical payment to keep people around at a bank with no future.

Friday, February 20, 2009

Nouriel Roubini has a newspaper article that says we are all Swedish now. I wish it were true. We are nowhere near being Swedish.

This is an investment blog – so – in tradition of investment blogs I am going to start with a stock chart.

This is a chart of a bank – I have removed the currency and the name of the bank.

The bank could be any bank that (nearly) collapsed in 1992 and recovered. It could be Citigroup or a small property exposed regional (such as North Fork). But it isn’t.

It is Skandinaviska Enskilda Banken, a Swedish bank which – at least in those days – was more upmarket and had a large corporate loan exposure.

It was in deep trouble. It was involved in a government support process which – had they failed various tests – would have wound up in nationalisation. The market truly believed that it would be nationalised. The only thing that kept it liquid was the implicit support that if it failed certain capital tests (weak tests because buffers were reasonably used by that time) then it would be nationalised.

It didn’t fail the tests. It got some private money. And the stock went to the races. The stock was a 20 bagger in 18 months. The bank however was implicitly supported by a process that could end in nationalisation. (That is it was solvent and would have been illiquid if not for implicit government support. It was a crisis - but a crisis alone was not enough reason to nationalise a Swedish bank.)

Here is another chart – this one is Svenska Handelsbanken – one of the better managed banks in the world. It too was loss making at the height of the crisis – and it had elevated losses for several years.

This bank did not even apply to be enrolled in the government support program (though it did consider it). It decided (with some justification) that it would get by fine. However the bank sure looked done for.

Swedish bank nationalisation wasn’t done by a traditional Swedish semi-socialist government. It was done by a centre-right reformist government for whom nationalisation was anathema.

They developed processes which were certain and which some adventurous money could recapitalise the banks under clear rules. The process respected private capital.

Banks that were deemed to require capital had to raise it – if they couldn’t they were fed capital by government. If they required too much capital the government wound up owning them. But there were defined rules and a process.

This is how it is – with certain rules and a process not every American bank is going to die - and possibly some or most of the big six will survive. Some will live – and they will prosper. Nationalisation with process leads to 20 baggers. Oh, and zeros - 100 percent losses.

But we are here in limbo. The nationalisation meme has taken hold – and nationalisation of some banks will happen. America is a current account deficit country – and almost all American banks need wholesale funding. There is none of that since the Lehman/WaMu week – and there will not be substantial wholesale funding until the rules are clear. All banks will fail in that environment.

The faster we come out with a good process – one which has nationalisation as one (but not the only) possible outcome then banks will continue to fail. And ad-hoc decisions will be made to bail them out or confiscate them. And we will be no wiser. And no closer to a solution.

Investing and nationalisation

Equity investors should not fear the nationalisation meme. It happened in Sweden and two of the banks were 20 baggers. Svenska Handlesbanken was a 50 bagger to peak (and it still trading well above 100 kroner).

The “all banks are insolvent” idea is simply not true – and it is not going to help you make money forever (though it will work until a process is found). But – hey – while there are no rules – it all a crap shoot. We own no American bank common equities at Bronte. Short a few.

Waiting, hoping… hoping we really can become Swedish. You make the real money on the long side...

John

A post script is required. SEB – which was an OK – but not great bank – got itself entangled in the Baltic mess. It is not quite as exposed as Swedbank – but it is not pretty. The stock is down from 250 to 50.

SvenskaHandelsbank has operations in the Baltic. Here is their Estonian page. But the exposures are substantially less large and the stock is one of the better performing European banks. Hey – best bank last cycle – best bank this cycle. A solid culture is the only way to run a bank.

A second postcript - in the comments it is noted that (a) the Swedish Kroner devalued sharply giving Sweden a strong competitive edge, and (b) the rest of the world could buy the Swedish product. It is much harder with a synchronised world downturn. No argument from me there.

I got a lot of comments on the “big post” – many are smart, some are just plain wrong, many however taught me stuff.

I should find the time to answer them – but for the moment I was just keen to see how many readers I had found in Washington DC.

I did find a few. Google Anlaytics allows you to track some user data (region, frequency, time on site etc.) Google tells me that I received my all time record Washington readers (about 200). Almost 80 percent of those had never visited Bronte Capital before.

Great – I am having an impact I thought.

But then I was pegged back a little. The average time on the site was one minute and thirty two seconds for a 5000 word essay.

As said - I received a lot of quality comments. I doubt I received any from people who read for less than 2 minutes.

John

Postcript... I know its just an average, and I know people cut and paste - but the New York crowd read twice as long...

Monday, February 16, 2009

Warning – a very long and wonky post - and possibly a little self indulgent. Don’t bother reading it unless you are really interested in banks and the crisis. More an essay than a blog post. If you are going to read it give me the courtesy of reading it to the end. If you are a direct report of Mr Geithner please read it now (the stuff you want is at the end).

It wasn’t the intention of this blog to become a public policy forum. It was just going to be a conventional investment blog. I used to be an (Australian and New Zealand) Treasury official and thought I gave up policy analysis when I ceased being a bureaucrat.

But the analysis of banks got intertwined with the analysis of politics. You can’t possibly decide what bank to invest (or for that matter short) without an understanding of where the politics is. If the government is going to keep giving money to banks (as per the Citigroup bailout) then you just have to own them. If the government is going to be harsh (as per the AIG bailout) then you want to run a mile. And they could be harsher than that. There are lots of possible outcomes – and the outcomes seem uncorrelated to the solvency of the institution. WaMu was probably solvent (subject to definitions below) and was confiscated – certainly – according to the FDIC – it had enough capital when it was confiscated. Wachovia was forced to sell itself when solvent (and when Wells happily purchased them later proving the point). AIG was shockingly insolvent and the shareholders were 80% diluted. Citigroup was in much bigger trouble than WaMu (it was actually illiquid) and the shareholders were given a big kiss (lots of very cheap government money and guarantees) and told to go on their way.

The government policy is very hard to determine. Under the Bush administration there was no policy. Each financial institution in crisis was handled a different way – think Bear, Lehman, AIG, Fannie and Freddie, WaMu, Wachovia, Citigroup. No two deals were even close to similar. Ad-hoc – thy name is Hank Paulson.

We have gone from an administration which demonstrated that it had no plan to the “Geithner Plan”. The “scare quotes” around “Geithner Plan” are because it is unfair to even call the “Geithner Plan” a “Plan”. As far as I can see there is no detail – and if you don’t have detail you don’t have a plan. I will remove the scare quotes when I think the Obama administration has a plan.

That said – lets put some framework around “the plan” – such as it is

First – let’s diagnose the problem – because I don’t even think the problem is well diagnosed.

We have a lot of pools of bank assets (pools of loans) which have the following properties:

The assets sit on the bank’s balance sheet with a value of 90 – meaning they have either being marked down to 90 (say mark to mythical market or model) or they have 10 in provisions for losses against them.

The same assets when they run off might actually make 75 – meaning if you run them to maturity or default the bank will – discounted at a low rate – recover 75 cents in the dollar on value.

The banks are thus under-reserved on an “held to maturity” basis. Heavily under-reserved. If you were to take correct provisions – many banks – not all but many – would have negative net worth. Few banks would meet capital adequacy standards. Given the penalty for even appearing as if there was a chance that you would not meet capital adequacy standards is death (see WaMu and Wachovia) and this is a self-assessed exam, banks can be expected not to tell the truth.*

Before you go any further you might wonder why it is possible that loans that will recover 75 trade at 50? Well its sort of obvious – in that I said that they recover 75 if the recoveries are discounted at a low rate. If I am going to buy such a loan I probably want 15% per annum return on equity.

The loan initially yielded say 5%. If I buy it at 50 I get a running yield of 10% - but say 15% of the loans are not actually paying that yield – so my running yield is 8.5%. I will get 75-80c on them in the end – and so there is another 25cents to be made – but that will be booked with an average duration of 5 years – so another 5% per year. At 50 cents in the dollar the yield to maturity on those bad assets is about 15% even though the assets are “bought cheap”. That is not enough for a hedge fund to be really interested – though if they could borrow to buy those assets they might be fun. The only problem is that the funding to buy the assets is either unavailable or if available with nasty covenants and a high price. Essentially the 75/50 difference is an artefact of the crisis and the unavailability of funding.

The problem with new loans

The difference between the yield to maturity value of a loan and its market value is extremely wide. The difference arises because you can’t eaily borrow to fund the loans – and my yield to maturity value is measured using traditional (low) costs of funds and market values loans based on their actual cost of funds (very high because of the crisis).

The spread between the origination value of a loan and its secondary value is huge. It simply makes no sense to originate new loans when you can buy old loans so cheap. Because it makes no sense to originate loans banks will not do it unless they are driven by an “institutional imperative” (they don’t know what else to do) or they are forced to by regulators or they are trying to prove their solvency by using capital (something I have accused Barclays of).

The irrationality of lending has dire economic consequences. At worst business just stops because they can’t get trade finance, working capital funding or any of the other basic services of modern banking.

Some reasonable numbers for the United States

Reasonable numbers are that:

The system starting capital (ie pre-crisis) was 1.4 trillion dollars,

Banks have raised about $500 billion along the way

Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS (such as Norwegian local government authorities), indeed the whole point of securitisation was that it took the loans and losses out of the banking system,

That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and

That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion.

The hardest of these numbers to determine is the end cumulative losses. The reason is that it is a prediction.** You can’t possibly know the end losses until the loans have run their course. Moreover the government response to the system will – to a large part – determine this number. If the government handles it very poorly then end losses will be larger.

The starting capital, capital raised along the way, losses outside the financial system are all just hard facts (though my quantification is not fantastic and there are serious quantitative difficulties such as double counting). The mark-to-market loss is able to be estimated because the market prices are observable – but banks are not happy to tell you what is on their books – and – more importantly – they don’t want to find out the price for those assets because they know above all that this is a self assessed exam for which the penalty for failure is death. For what it is worth I suspect the end cumulative losses will be at the low end of my range and that the mark-to-market losses will be at the high end of my range (ie that Roubini is an optimist on mark-to-market losses).

The other observation is that the starting capital for the US banks was high. The regulators in the US by-and-large forced banks to have a lot of capital. They were more lax in Europe and totally lax in the UK. The UK problems arise in part because the banks started the cycle massively capital deficient.

Are the banks solvent?

It has been the blogosphere (and now commentator) meme-of-the-day that the US banking system is not solvent. See Paul Krugman, Yves Smith or Felix Salmon for examples. But I am not sure that anyone even defines solvent appropriately. So let's think about different definitions of solvency – and whether the banks meet them.

There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:

Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?

Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?

Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?

Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.

Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?

Let’s look at the banking system against each of these definitions of solvency. That should clear the woolly thinking up on solvency.

Solvency against definition 1: does the banking system currently contain adequate regulatory capital.

To this definition the answer is not likely – and though if you ran for three or four years you might get there. The US banking system started with 1.4 trillion – which was quite near regulatory limits. In the great boom it was just assumed you wanted to run with as little capital as required because that got your return on equity up. So the starting capital was somewhere near required capital. As say 1.5-2 trillion has been lost (on the yield-to-maturity-definition) and only 500 billion or so raised so collectively the banks are likely to be short. Pre-tax, pre-provision operating profits (probably greater than 300 billion per annum with normalised funding costs) would not cover the difference.

There will be disparity amongst banks and some will actually have gone negative regulatory capital (including probably WaMu had it been left). The regulatory insolvency is far greater if you were to mark the assets to market but outside the brokerage area most banks don’t have to mark assets to market – and inside the brokerage area they really want the mark-to-market rules suspended.

Trading books (or loans originated for sale) are by accounting standard mark-to-market. This is a big problem because the market price is substantially lower than the yield to maturity value. If a bank did a lot of trading (eg Citigroup) or originated a lot of loans for sale but was stuck with them at the end (eg Royal Bank of Scotland on its private equity loan book) then it is likely to be deeply insolvent on a regulatory standard because it needs to mark those loans down to a the very low market price. These institutions are squealing for a suspension of mark-to-market rules – and I would have some sympathy if I could get them to account for it on a reasonable yield to maturity basis with reasonable reserves. I don’t trust them – after all – they are bankers and they lie.***

Nonetheless regulatory capital is not where it is at. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. It’s perfectly normal (and in my view acceptable) to have inadequate regulatory midway through a nasty downturn. Dividends should be cut, profit should be retained, even growth curtailed – all of which are how banks get back to normal regulatory capital – but confiscation or nationalisation of banks because the regulatory buffers have been removed is harsh – and unreasonable behaviour.

Solvency against definition 2: do the banks have positive net worth under GAAP?

This is a much less strict test than the regulatory capital test. It’s a test of whether there is capital there – not whether there are buffers there. You would not expect there to be broad buffers at this point in the cycle (after all the point of a buffer is that you use it when you have a crash) but soundness requires some buffer.

My view – and it is open to debate – is that a reasonable sort of regulatory buffer is that a bank – properly provisioned when the disaster happens – should be forced to have about a third required regulatory capital – and should be restricted from reducing that capital (dividends, buybacks etc) until the buffers are fully restored. Forbearance is right at this point of the cycle – unlimited forbearance is not. And Test 2 here is too weak for most policy application.

Nonetheless on Test 2 the banks almost certainly collectively pass. The losses (yield to maturity basis) are unlikely to be more than 2 trillion. We started with 1.4 trillion of capital – will have made probably 400 billion on pre-tax-pre-provision profits and having raised more than 500 billion. Moreover – the whole point of securitisation and the “shadow banking system” was that it moved considerable losses outside the banking system. As losses were moved elsewhere – whether that be to dumb hedge funds (of which HF-Implode has a large list) or to Norwegian local government.

Now I have a metaphor for how you might think of Test 2. In the centre of the road are double lines. You are not allowed to cross them. Crossing them is dangerous (you might crash and you might cause injury to others). When you cross them you should get back to your own side of the road quickly. However there are times of driving stress when you would cross them and that crossing is considered normal and acceptable. A child runs out on the road – and under stress you swerve over the double lines. Nobody will confiscate your car and lock you up for that. However if you stayed over the double lines you would expect the government to come down on you. Breaching regulatory capital buffers is normal in times of stress – but staying at very low to zero levels of negative capital – that is suicidal.

If we consider a modified Test 2 – whether the banks have collecting a third of required regulatory capital right now (say 500 billion) then it is harder to determine collective pass or failure – but my guess is pass. The losses in the system are indeterminate – but on a yield to maturity system 1.5 to 2 trillion seems about right. Now there may be 500 billion losses outside the banks (that is the shadow banking system). We started with 1.4 trillion and have raised a bit along the way. If losses are 2 trillion total – 500 billion outside the system and you have some operating profits along the way you get a bare pass.

The situation of trading books under Test 2 however is much more dire. Trading books under GAAP are mark to market – and as noted above the market values of assets are considerably less than the yield to maturity values. (The Roubini number of 3.4 trillion in mark-to-market losses comes to mind.) If these insitutions are forced to account honestly according to GAAP – that is to mark their own book appropriately – then they are likely very insolvent indeed. The mark to market losses (which are in excess of yield to maturity losses) however are offset to some extent by the phoney mark-to-market gain resulting from reducing the value of their own liabilities because of reduced credit worthiness. The banks that are in this situation (insolvent under mark to market) include Citigroup, JP Morgan, possibly Bank of America now that it has swallowed Merrill, and possibly Goldman Sachs.

This test requires adequate ability to repay the debts of the banking system and have some value provided the banking system is able to function. Before I go any further I should mention the proviso is critical. At the moment the banking system (indeed anyone) has a hard time getting cheap funding. This test presumes that the banks can fund themselves more-or-less-normally (either because times are normal or because governments have guaranteed the funding making the funding problems go away).

Here I am counted as a radical. The system in my view clearly has positive economic value. I did that calculation in my voodoo maths post. To me the issue is unequivocal. The pre-tax, pre-provision income of the banking system normally funded is probably 300 billion. It is probably much larger if the funding costs were reduced to near Treasury levels. If you haven’t noticed interest rate spreads and hence pre-tax, pre-provision profits of the banking system should (presuming normalised funding) be way way up. 300 billion is an underestimate. So if there are 2 trillion of losses and 1.4 trillion of starting capital then four or five years and we are back to fully capitalised. We would get back there faster than that – because the banks have raised considerable capital on the way down and not all the 2 trillion of end losses are born within the banking system. Indeed against "Test 3" I think the system is brimming with solvency. Individual banks are possibly insolvent against this test – but the system is not and anyone that tells you otherwise is just not doing maths.

The usefulness of this test however is problematic. It presumes the system can continue to operate (a test falsified by the facts on the ground). It is however an indication of what would happen if the system were nationalised – the government would make a profit. It is also the test of what would happen if the system had credible government guarantees and were sensibly run. (If you are going to give it government guarantees then – in my view – you might as well nationalise it. However at the very minimum you need to control it to an enormous extent because government guarantees cause nasty moral hazard problems.)

Test 4: do the banks have positive liquidation value?

This one is easy – no way. There is nothing wrong with the Nouriel Roubini number about 3.4 trillion in total losses if all assets on bank balance sheets are marked-to-market. Indeed if anything Roubini’s number is light. Bluntly speaking if you liquidated the banks now the losses would be huge – and they would be huge for almost all banks including those that met regulatory tests in "Test 1". The losses would be huge for the same reason that the banks are having trouble – nobody could lever up to buy the assets at anything that looks like a reasonable “yield to maturity” value. Incidentally it should be noticed that a bank which has adequate regulatory capital and has been well run will be profitable in run-off but have negative liquidation value. It is rough in the extreme to use liquidation value as the test - though in the event of widespread confiscation liquidation value is the test that will wind up being used.

Test 5: do the banks have enough liquidity?

Well this is hard – and critically dependent on government policy. Solvent banks (even "Test 1 Solvent Banks") will be "liquidity insolvent" if there is a run. And when people who provide funding lose in a run then any thought of runs will be self-fulfilling. So far several banks have failed "Test 5" – notably various brokers and Citigroup (which is a broker). The ability to pass or fail "Test 5" however comes mostly from the faith that people have that you will pass "Test 5". If you pass "Test 3" above (and the US banking system does) and people have sufficient faith then you should continuously pass Test 5.

Government policy however has been arbitrary and capricious. The Hank Paulson plan was no plan. It was ad-hoc. The “Geithner plan” is so vague as to be meaningless. WaMu which was adequately capitalised but had a minor run (induced by leaked rumours of a government takeover) was confiscated. Citigroup – which – being a broker – is almost certainly insolvent from a GAAP perspective – and which had a major liquidity squeeze was given a big-fat-sloppy-kiss (lots of cheap government capital). In the WaMu case the intermediate funders had any rights confiscated. That I thought at the time was reckless and irresponsible. I still think that.

If the government doesn’t get a consistent plan – and that consistent plan does not appease intermediate creditors of banks (as argued in the “reckless and irresponsible” post) then we might as well nationalise the entire US banking system now – because almost all banks are dependent on intermediate funding – and that funding has fear-of-government.

An observation

If you believe these numbers – and I do – then there is no need to nationalise the banking system in the US provided that you can get confidence back into the system. Now that is a big proviso – I have some methods of getting confidence back into the system – but they are harsh. Mostly it can’t be done with the current tier of executive management (who are utterly discredited). It also can’t be done unless government policy becomes consistent and appears to be consistent. A strong plan is necessary.

Nationalisation will work though as a way of bringing confidence back. I first mentioned nationalisation (as something that would work) in June 2008. One big name Wall Street journalist (who now thinks I was prescient) thought that I was mad then. I thought nationalisation might happen if government policy were badly executed. So far government policy has been badly executed - and the takeover of WaMu (which kicked the intermediate debt holders and hence put the fear-of-government into people that fund banks) is exhibit A. (I thought the end consequence of Sheila Bair’s action would be the nationalisation of the whole US banking system though I still harboured hope for better. I hoped that Hank Paulson – and later the Obama administration would be better than that. So far I am very disappointed.)

Anyway – there would not be a crisis if people trusted – even if the banks were marginally insolvent. However banks have told lies – blatant lies – for so long that nobody believes them. Certainly the blogosphere has decided that banks are insolvent no matter what they say – though the evidence for insolvency (other than mark-to-market insolvency as per Nouriel Roubini) is thin to non-existent. Mark-to-market insolvency is the norm.

Nationalisation, insolvency and process

Now when a blogger or an analyst tells you a bank or the system is insolvent then ask them what definition of insolvency they are using and test them against that definition. Then test them against others – and work out – in the context given – whether the institution is solvent against the definition appropriate for the circumstances. People who do not think clearly as to definition of insolvent are being sloppy – and that includes most the bloggers I most admire including Paul Krugman. The context in which the banking system is insolvent is that (a) it is illiquid because people don’t trust it and (b) it can’t get enough liquidity because it has to sell assets into a market in which they are trading considerably below their “yield to maturity or GAAP price” and if you sell it at that price you reveal “mark-to-market” insolvency as per Roubini. However provided the banking system could remain liquid it is unlikely it will actually be insolvent though individual banks might be. [I should note that this is a US conclusion. The UK banks started much more thinly capitalised and I think they are insolvent.]

This is what the stakes are in the (so far incompetent) government policy as to how the banking crisis is to be dealt with. What is a marginal solvency crisis (and that is all it is on a yield to maturity basis) is being turned into the mother-of-all-liquidity-and-solvency crises. Sure the banks bought in on themselves by telling so many lies in the good times (so they are never believed now). But now the problem is beyond their ability to control.

Anyway wholesale nationalisation is not the right policy per-se. It will the inevitable result of following the wrong policies. The right policies will involve selective nationalisation – what I have described in other posts as “nationalisation after due process”.

The “Geithner Plan”: module 1 – stress testing

The first element of the “Geithner Plan” is a stress testing of banks. This is so vague as to defy description. That hasn’t stopped Calculated Risk from thinking that this should start quickly and will be quick – though Yves at Naked Capitalism has it right.

Fannie Mae (according to its 2006 10K) spent almost a billion dollars in 2006 alone trying to remedy its accounting from its 2004 accounting scandal. Hey – that was just Fannie Mae. If you want to do a proper stress testing with qualified people across the banking system then your accounting bills will be in excess of $3 billion dollars. At the end of one post I jokingly called this “stimulus” – but it is – lots of work for underemployed business accountants.

At Fannie Mae I do not need to remind my readers the money wasn’t well spent.

Anyway the words “stress testing” in Geithner’s speech do not constitute a plan. Not close.

There is one stress test that it doesn’t cost a billion in accounting bills to do – and that is to say – hey – you got only 8 percent reserves against that pool of loans – why don’t you test that in the market. If you can sell those loans – even a few of them – at 92 cents in the dollar then we will think your reserves are sensible. Having done that we can believe your assumptions and stress test using the bank’s existing assumptions. The only problem – and it is a big problem – is that the secondary market price of the loans is way below the yield to maturity price – and if that is the test that you are going to have then you will reveal Nouriel Roubini type insolvency – because the whole system is grotesquely insolvent on a mark-to-market basis. A market based stress test can’t be done unless you fix the secondary market up.

Again the word “plan” is a misnomer here. More a statement of hopeful intent. I jokingly put some figures around it with a blog post that suggests that Geithner get the US Treasury to lend Bronte Capital a trillion dollars under favourable terms. I figured with such a loan that I could start making substantial money.

But the idea deserves more consideration than I gave it. If instead of one fund with 150 billion of private money and say 1050 billion of public money you established ten funds of one thirtieth that size then you could produce a functioning secondary market for the dross that banks are taking off their balance sheet. And this leads to what I think is the obvious meld of “module 1 and module 2”. That is (a) establish the funds – but with a rule that they are expected to – and only allowed to bid on the assets sold by banks on their stress test, and (b) having established the market for the secondary assets (admittedly supported by cheap money) you can get the banks to redo their reserves by selling sample assets into that market. This allows you a market redo of the accounts – and hence to avoid the problems that caused Fannie Mae to waste a billion dollars redoing their accounts.

If they have inadequate capital after testing in that market then you have the basis for forcing them to raise more capital or putting them into receivership – you have a functioning due process.

When the banks are illiquid rather than offer guarantees you beef up the secondary market by establishing more funds (with private money at risk in those funds). You have the banks sell their assets to gain liquidity.

This is a workable plan along Geithner lines. It won’t necessarily result in wholesale nationalisation – and I hope that I have convinced you that nationalisation is the end result of failure of policy rather than a policy goal in itself.

At worst it gets maybe a hundred billion of private money into the fray. It has all the requirements of due process. It should be a good plan.

Thanks for reading this far.

John Hempton

*It was Warren Buffett who first – at least to my hearing – described financial accounts as a self-assessed exam for which the penalty for failure is death. I think he was talking about insurance companies – but the idea is the same. Truth is not expected.

**Estimating the end losses for loans is always problematic. The modal outcome is near to zero (most loans pay) but the tails are fat. We live in a time of fat tails – and getting a handle on this number requires that we pretend we as much about the future as we do about the present. (And we know the present fairly poorly because – as I have pointed out – bankers almost always lie.)

***Note also it was acceptable to pay bonuses to traders based on mark-to-market profits. Now they want those rules suspended. Cynical comments are allowed…

Friday, February 13, 2009

I was not at Bondi yesterday evening - but I was the evening before - but at the North end - teaching my son to surf. The conditions were very similar - dusk, extremely low tide, overcast, weeds washing into the beach.

Think of Nitto Denko as Japanese 3M. Indeed it is the company in the world that most resembles 3M. It does tapes, films, laminates – the usual 3M product set. Like 3M a large part of sales winds up in automotive uses.

Compared with January 2008 , Nitto Denko's total consolidated sales revenue was down 51% (Y-o-Y) and decreased 9% from December 2008. LCD-related product sales was also down 57%(Y-o-Y) and decreased 1% from December 2008.

And far from me to encourage you onto a crowded trade – the position makes sense.

There are plenty of assets trading at 60-70c on the dollar that sit on bank balance sheets at much higher prices. If you force the banks to recognise the assets at 70c on the dollar they are amazingly insolvent.

So either

(a) the assets are underpriced, or

(b) the banks are overpriced or

(c) both.

Long junky loans short financial institutions is just an old fashioned arbitrage – and the few unimpaired arb funds (eg Paulson) are making hay...

Are the junky assets really underpriced in the market?

There are plenty of assets trading at 60 cents on the dollar. Diversified pools of mortgages (admittedly less-than-prime pools) often seem to trade at this level. AAA strips against those pools are often 70c in the dollar and where 12 percent of the assets need to go bad before you bear any loss. Implicitly there needs to be 40 percent losses before you lose money on these investments.

I know it is bad out there – but 40 percent losses imply worse than 60 percent defaults with 60 percent loss given default. It is simply not going to happen on a widespread basis (though I can show you individual securitisations that are worse than this).

So why don’t people bid up the price of the junky assets? Well some are – see the Paulson letter – and he has made good money doing things like that.

But there is a return problem. Some of these assets are quite long dated – you might get paid over ten years. And meanwhile you get say 10/7 times the AAA yield (the stuff is trading at 70c in the dollar) and it might pay 85 cents in another 10 years – so you get nearly another 2% per annum in carry.

Well 10/7 times treasuries isn’t very much – less than 4% and nearly 2% carry – and whoa you have an asset on which you won’t lose money indeed on which you probably will make five percent.

That really excites me. Asset prices are way down – this crash might be the investment opportunity of a lifetime – and I have a smorgasboard of assets to chose from on which I will not lose money over the long term – indeed on which I might make 5% per annum.

I am just thrilled.

So how are those assets really? Underpriced but hardly exciting. To be exciting they have to be insanely underpriced. There are a few insanely underpriced assets out there, but John Paulson (Paulson funds) won’t tell you what they are. And even then they are not that exciting.

No – to be exciting you need to borrow against them. You need to be able to use leverage. Cheap leverage. Lots of leverage. And it can’t be margin loans or the like – because the asset prices are so volatile that your funding might go away.

But – with permanent cheap funding at government rates it should be profitable to buy those assets. Seven to one levered at government rates (which are a couple of percent) the returns will be spectacular.

So if the Geithner plan is to attract say one hundred and fifty billion of private risk capital and allow it permanent and secure access to say a trillion dollars of government money at a government rates then hey – I am in. (I would require the interest rate risk be matched too.)

It would be a pretty big gift from the government – as nobody – a good bank or a bad bank – can borrow at the same (extraordinarily low) rate as the US Treasury. But as a plan it might just work. And because 150 billion of real private spondulicks is at risk there are some pretty strong incentives for the private sector manager to get it right.

Well who should be the private sector manager?

I don’t know. Most of them won’t work for a $500 thousand dollar salary. And that is problematic.

But – hey its my civic duty. I will do it.

Yes – you heard me, I would do it for a $500K salary. And no base fees – and a very small performance fee. Admittedly the very small performance fee will be on a very large amount of money – and with all that cheap government leverage it might leave me as rich as Croesus – say Bob Rubin rich. Indeed as the underpriced assets are common and the only problem is the inability to lever them – I should make an absolute killing if Mr Geithner will give me enough cheap, matched and permanent funding.

Indeed I would never bother with this fund I am setting up. I would get my original clients together and raise a few hundred million of private money to start the bail out fund. I will even put in most my own net worth.

Calculated Risk points us towards a slide in the presentation that JP Morgan made when it purchased Washington Mutual. Calculated risk (falsely I think) indicates that it is relatively easy to quickly put up a stress test scenario as to end losses for various types of loan.

Anyway – back to the slide which you can find here. It presented three scenarios up to and including a “severe recession”. It is now clear that the unemployment rate will exceed the severe recession scenario in the slide. However home price appreciation (well really depreciation) from peak to trough is still considerably less than the severe recession scenario in the slide and it is still not clear we will get outcomes that bad.

When that slide was presented I thought it overly – indeed insanely bearish on housing losses – and I still do. WaMu had loan balances of 176 billion and JPM was predicting a loss over the history of those loans of 54 billion in its severe recession scenario.

To get that loss more than half the loans WaMu made had to default. If you assume any reasonable recovery the default rate probably had to be north of sixty percent.

Even in a severe recession that seemed unlikely to me. I know a few WaMu customers (middle class, northern California, financially stressed) and whilst some might default it seemed unlikely that half would.

There is – in America – a core group of people who believe that you should pay your home loan. It is bad out there – but WaMu did have some old loans in its book – which even with 40 percent house price depreciation were going to have positive equity. Also WaMu’s book was at least in part diversified by states.

If you believed in $54 billion in losses (and I don’t) then it is right that WaMu equity was worthless or near worthless even if Sheila Bair had granted some forebearance.

Why financial institutions lie

Most the time problematic banks have an incentive to spin their position as better than it is. Banks lie about the quality of the assets on their book. They do it all the time because if their capital appears adequate their cost of funds will be lower and the availability of funds will be higher. Having funds available at low cost is central to bank profitability.

Most banks have huge and responsive investor relations functions – because continuously convincing the market of their credit worthiness is a core operating function. The guys staffing these IR departments are usually nice enough – but unless you can piece together their statements over a period of years then you are probably best advised not to believe much they tell you.

Bank IR and financial management are very practiced at spin.

They will really get to lying if the Government chooses to buy bad assets from them. I can just imagine the scene – lying bankers (there is no other kind) on one side – and suckers – also known as taxpayers – on the other.

There are exceptions to the rule that financial institutions spin the positive. Ambac (a credit insurance company) is a company that is brutally bearish with you if you go do an investor relations meeting. I have done that – and you come out wanting to slash your wrists. Ambac is writing no business. It is trying to settle old claims presumably for less than the present value of the claims that they will have to pay. If they can convince people that there is a high probability they will not be around in six years to pay the claim then claimants might settle for 60 cents on the dollar now. Indeed the only reason why you wouldn’t settle for 60c on the dollar now on an Ambac claim is that you haven’t taken the hit in your own balance sheet. [Barclays is an offender here. It will not settle some claims because it does not want to recognise its own losses. Oh, and there is a high possibility that Ambac will not be around to pay the claims which will be problematic for some...]

Anyway because Ambac is trying to settle claims they have an incentive to make their credit look worse than it really is – that way you get to settle the claims cheaper. [Funnily MBIA is not playing that game. My view is that MBIA is worse than Ambac – but is pretending it is better.]

The incentives on JP Morgan

Consider the situation that JP Morgan was in when they were negotiating with Sheila Bair to convince her to confiscate WaMu and to hand it to them. JP Morgan had previously been willing to buy WaMu for $8 a share. They had done due diligence on it twice. But here was the opportunity to buy it for less-than-nothing – if you could get it confiscated first.

Bluntly JP Morgan had an incentive that few banks actually have – which is to high-ball the loss estimates. Their job was convince Sheila Bair to confiscate the bank. How do you do that? Well you tell bad stories. You have to make it seem that even in modest recessions (their severe recession case was a modest recession by current standards) that the losses would be enormous.

So – consistent with incentives – they high-balled the losses to Sheila Bair – and then – to be consistent – they highballed the losses in the public presentation. They were of course doing what bankers do – which is lying when they have the incentive to lie.

Calculated Risk swallowed that lie. They know better than to swallow overly bullish lies. They should also know better than to swallow overly bearish ones.

General rule: believe nothing bankers say when their incentive is to lie. Verify everything you can. If you can’t verify then discount veracity appropriately. If they are investment bankers they lie more convincingly than regional bankers – though both are pretty convincing.

John

PS. This was a situation where a banker (Jamie Dimon) was buying something (WaMu) from the government (Sheila Bair). The lying banker got the better end of the deal.

It won't be any different if banks sell things to government. The lying banker will get the better end of the deal. If the private sector is in for 10% of the equity it will help but not solve the problem...

PPS. I suspect I am meant to comment on the plan. I don't think there is a plan. Stress test everything is not a plan. Indeed I think the stress tests have the same lies built into them that everything else does. Third party assessments is a plan - but it requires an openness that banks are not familiar with - and perhaps a billion dollars in accounting bills (which is I guess stimulus).

Tuesday, February 10, 2009

I do not want to say much about the Australian fires - but this photo of molten metal from burnt cars gives you some idea of their intensity.

For the record - apparently these were aluminium alloy wheels. The melting point is just under 1000 kelvin. Way hotter than lead (600 kelvin). Iron melting point is 1800 kelvin - furnace temperature. There are incidents of iron being serious impaired (eg children swing sets that collapsed with heat damage) but I have not seen plausible photos of iron melting like this...

This is a good but dull book - a handbook of upstream oil process – how a drill works, all the processes involved in guiding drills, essentially a technical manual aimed at scientists and engineers who want to get up to speed (and hence useful) in the management of upstream oil and gas. If that is what you want I highly recommend this book.

I do not believe in investing in any industry until you understand it – and this will give you a very good understanding of the oil and gas industry. If your fund manager doesn’t read stuff like this then find a different fund manager. (This book is about widening your circle of competence. I am hardly recommending it for general reading – but we found it useful.)

The real purpose of this post

Norman Hyne is very matter-of-fact. For instance – without reference to whether such a thing should exist – or without reference to the vast scientific revolution that was required even to say such a thing – Hyne talks about 14 thousand feet of sediment. Sometimes he talks about 20 thousand feet of sediment. And it goes without saying that the world must be very old for this sediment to exist. The author won’t even bother entertaining the idea that the world is 6000 years old (and that the sediment was all laid down in some biblical flood). That notion is of no use whatsoever to a field petroleum engineer.

Likewise there is a chapter on analysing drill core samples. This is done by analysing micro-fossils – weeds and seeds. The organising principal of the theory is evolutionary biology. Creation Science is not entertained. Norman Hyne is a practical guy – and he wouldn’t mention such “theories” because they are no use in drilling for oil. Indeed you will find no worthwhile petroleum geologists who view creation science as a useful theory in finding oil.

We have just had a US President whose fortune was built on oil. We had a VP who was CEO of Haliburton – a major upstream oil contractor and technology provider. These people know that Creation Science is useless – that it will not help you find oil or make money.

Yet – admittedly with political considerations at heart – they were active or passive supporters of creation science crap. They knew it would keep the constituents poor or stupid – and yet – for understandable political reasons they backed it.

One of the more famous conservative blogs is called the Conspiracy to Keep you Poor and Stupid – but I have only once found such a conspiracy. And that was on the conservative side of politics.

I have said on this blog that conservatives sometimes have a better grasp of reality than liberals. They tend to have a more realistic view of the human condition than many starry-eyed liberals. However this is another example of conservatives becoming the anti-science reactionaries of American politics. Lots of real reform (eg greenhouse) will not be done well until conservatives engage properly with the reality. This is yet another plea for American conservatism to get back its intellectual strength. It really is time...

John Hempton

I have been criticised in the email and in the comments for a political sermon - the belief that creationism is a straw man to beat the political drum on.

I wish it were true. Over half the US population in some surveys believe this crap. I have seen high profiles conservatives describe evolution as "the liberal creation myth".

These are the same conservatives who have anti-science belief elsewhere. Everytime I mention greenhouse the blog goes wild. The temperatures of over 120 farenheit that my parents in law (rural southern Australia) experienced on the weekend may not be driven at all by the greenhouse effect - but my feeling is that the burden of proof is now totally on the climate-change-deniers. A couple of hundred dead (in the resulting fires) tends to focus the mind - and my mother in law - usually a tough old woman - spent most of Sunday crying...

Once Maggie Thatcher argued (indeed demonstrated) that lots could be achieved if you appealed to individualism. She was right. She had a decent understanding of the human condition. I might not agree with all she aimed for - and ultimately I think there are non-market goals. But the position had strengths and we should keep the good bits of it.

But the Maggie Thatcher view that financial markets could regulate themselves is now a smouldering ruin called the Royal Bank of Scotland.

How we get a facts-and-circumstances driven politics is something that regularly makes me ponder. Its is also the central political question of the next ten years - how we keep the good bits of the Thatcher/Reagan revolution (a general belief in markets and the worth of the individual) whilst tossing the bad bits (lack of environmental responsiveness, failed financial market regulation etc).

If I sound like I am giving a sermon I apologise in advance. But my guess is that the same people who believe in creation science are the people who believe that climate is the realm of god - not the realm of human ingenuity and destructiveness...

J

Finally - the real issue with greenhouse for this blog is the notion that it is real and it will effect investments. For instance if heat-waves of the kind experienced in southern Australia are common then fruit trees in the Goulburn Valley are not worth what they used to be. (You have a hard time growing peaches when the temperature is 120 farenheit.)

Likewise governemnts will do things and that will change the value of all sorts of assets (coal, nuclear, hybrid cars and lots of things I can't think of). All of that is worthy of consideration.

Thursday, February 5, 2009

The Spanish banks always looked vulnerable to me. I have criticised Santander several times on this blog.

But this story deserves more coverage. Ibex Salad – a blog about the Spanish stock market and olive oil business – is reporting that banks are taking the property they are repossessing from bankrupt property developers and selling it to their own staff at a 35 percent discount and with 100% percent financing.

This is called loss deferral. That is what distressed banks do.

But Ibex Salad makes the obvious point. For employees this has one side benefit – staff who borrow from the bank are more likely to keep their job. Probably a good deal for the bank staff – even if they are paying slightly over the odds.

However I have come across this retailer in relatively good categories with a very low valuation and acceptable looking – though economically cyclic - run of same store sales increases. Here are the numbers:

Fiscal year

Same store sales

1992

1%

1993

7%

1994

8%

1995

15%

1996

5%

1997

-8%

1998

-1%

1999

8%

2000

8%

2001

-4%

2002

-10%

2003

4%

2004

-3%

2005

1%

2006

8%

2007

6%

2008

-8%

The same store sales were up 50 percent over the period 1992 to 2007 – not a great 15 years – but not diabolical. They were down 8% in 2008 – which – given the economy looks bad – but again not pinch yourself bad.

And this stock looks cheap. Really cheap. Breathtakingly cheap.

I am going to leave a few spaces before the rest of this post….

More space…

And more…

So it’s a bait-and-switch – the company is Circuit City – and whilst the same store sales look sort of acceptable they were anything but acceptable when compared to the competitor. Here are Circuit City’s same store sales compared to Best Buy:

Fiscal year

Circuit City

Best Buy

1992

1%

14%

1993

7%

19%

1994

8%

27%

1995

15%

20%

1996

5%

6%

1997

-8%

-5%

1998

-1%

2%

1999

8%

13%

2000

8%

11%

2001

-4%

5%

2002

-10%

2%

2003

4%

2.4%

2004

-3%

7.1%

2005

1%

4.3%

2006

8%

4.9%

2007

6%

5.0%

2008

-8%

2.9%

And now you can see what happened. Circuit City just got crushed. Best Buy had superior sales per-square-foot or sales per unit of cost structure – and that difference got bigger and bigger and bigger.

As it did they could cut price – so whilst Circuit City’s same store sales sort of kept up with the costs their gross margin per unit of costs most certainly did not.

It is impossible to analyse the stock except in the context of its competition. Circuit City’s problems are not it sales per-se – but its sales relative to its competitors. Underperform by that much for that long and – despite your glorious past – there is nothing left. Every investor should have emblazoned on their forehead that “competition is a wealth hazard” and anyone that tries to sell you a stock without analysing the competition should be sacked. [Simple but blunt.]

I visited Circuit City headquarters once. In those days it had a billion dollars of unencumbered cash on its balance sheet. That cash represented past profits. Past glories of which there were many. Circuit City was a fantastic company once…

Circuit City it seemed tried many things to get the sales up (and match Best Buy). The above mentioned cash disappeared when CC had a bad experiment in credit cards. It should be easy enough to drive sales if you lent to people who had no intention of paying you back. Given that, it is surprisingly hard to find the credit card boost in CC’s numbers.

Also about just before I visited them they (finally) got rid of whitegoods – and tried to match the software (music, DVDs etc) offering at Best Buy. They had to refurb all the shops. Lots of cost – and only a few years of interesting same store sales growth.

People seemed to be down on Circuit City sacking its expensive sales staff and rehiring cheap ones a few years before insolvency. But the expensive sales staff hardly helped the sales keep up with Best Buy and would have been sacked anyway when the company was liquidated. The problem lay elsewhere and being sacked two years ago was a relative blessing (the new hires will be hunting for work in this labour market).

Consider this an open thread. What is it that Circuit City did worse than Best Buy? I have my ideas – and will jot them in the comments where appropriate – but I really want yours.

Also – if anyone has a good memory – can they tell me why both companies had lousy sales in 1997?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.